City regulators have started an exhaustive manhunt for the perpetrators of the smash-and-grab raid on HBOS, the bank which saw 20 per cent wiped off its value in an hour through unfounded market rumours about its financial health.
Totally false speculation caused panic selling of HBOS shares on Wednesday, prompting an unprecedented reaction from regulators furious that unknown speculators with short positions in the bank had made a killing by deliberately planting the untrue gossip.
The Financial Services Authority, the UK markets watchdog, has recently beefed up its market monitoring operation, but many analysts warned yesterday that the culprits, who some claimed had put the entire UK economy at risk, will never be found.
Within minutes of the London market opening for business on Wednesday, HBOS had shares plunged 18 per cent to 398p, smashed by rumours that liquidity problems had forced it to go cap in hand to the Bank of England.
As soon as the speculation circulated, suspicions were raised. Credit Suisse's equity desk immediately put out a note saying HBOS was getting "toasted" on rumours that "look like market manipulation".
Yesterday, some said the rumours had been sparked by an anonymous email circulating talk that the Financial Times was to run the story of HBOS's so-called problems. Others said it was spread by untraceable mobile phone conversations.
Either way HBOS was forced to release a swift denial, as was the Bank of England. Finally, the Financial Services Authority said the share price movements constituted market abuse as regulators sought to prevent queues forming outside the bank's branches nationwide as with the collapse of Northern Rock.
The regulators blamed "lies" spread by short sellers for the slump in HBOS's share price, but the question is who was peddling them. Hedge funds, banks' proprietary trading desks and wealthy individuals all employ short-selling methods. But the sheer scale, and gall, of the attack on one of Britain's premier financial institutions only pointed one way, according to sources in the City.
One trader at a banking group in London said the problems probably stemmed from the opulent surroundings of Mayfair, the headquarters of many hedge funds in the UK. "This is almost definitely the work of hedge funds; it is very unlikely to be a bank or individual doing this. There are so many firms out there, most of whom are highly respectable, but there are some cowboys at the outskirts of the industry. What went on during Wednesday was very, very dodgy."
He added: "I don't think this happens much, but these are desperate times."
One source close to the hedge fund industry said: "There are traders with too much flexibility and managers who turn a blind eye."
The accusation is as difficult to deny as it is to prove. Hedge funds are perceived as aggressive and opaque, use complex trading strategies fed through a series of offshore funds with little disclosure in the public domain. A hedge fund source said: "The problem is we all get lumped in together when something like this happens because most people don't understand how hedge funds work."
The tactic of short selling is a perfectly legitimate trading practice, but when used illegally – the so called "trash and cash" trade – the results can have dire implications. One market expert said: "The problem with market abuse in short selling is that you can drive a fundamentally sound company to the wall."
In the case of HBOS, the effect could have been even more disastrous, according to one lawyer. Patrick Buckingham, a partner at Herbert Smith who advises clients on market conduct, said: "If certain investors are adopting trading strategies that could lead to the collapse of a fundamentally sound bank, it is very worrying indeed. In this case it is actually creating systemic risk in the wider economy, all for individual gain over a very short term." He added: "With insider dealing trades, from a stock tip or whatever, it is clear market abuse, but the man in the street is not affected. If a retail bank goes down many of us are affected because a lot of ordinary people will have accounts and mortgages with it. This is really quite scary, as the underlying business is basically sound."
One financial market source said: "If some rogue traders destroy HBOS, a fundamentally sound business, where does it end? Will we see that move on to HSBC and Barclays?"
The FSA's anger over Wednesday's events was evident. The watchdog has previously said it wants to put the "fear factor" into market abusers, and Sally Dewar, who heads up its wholesale and institutional markets division, said: "We will not tolerate market participants taking advantage of the current market conditions to commit abuse by spreading false rumours and dealing on the back of them."
The regulator now has to track down the market abusers, a task that several industry participants called "nearly impossible". Its 40-strong market monitoring team, which has been built up in the past year, has launched a heavy investigation into the movement in the financial stocks.
The FSA yesterday said it would use "good old fashioned police work" in tracking the wrongdoers, looking at transaction histories and transcripts of telephone conversations. So far it has approached market participants for information, and some have come forward. This will run alongside the information provided by its electronic system, Sabre, which keeps a database of all market transactions in the UK. A spokeswoman for the FSA said: "We can't necessarily identify short selling specifically, but we have systems that give pretty good indicators." The transaction data for Wednesday, will not be ready for examination, however, until next Tuesday. Sabre, the Surveillance and Automated Business Reporting Engine, can "see those who sold out shares and bought them back quickly, which is generally a good indication of shorting." The FSA is desperately hoping for its first ever success in securing a case against traders misleading the market, although it has instigated several actions. "We've never brought a successful enforcement action on this charge," the spokeswoman said.
So far, the most high profile hedge fund manager to be fined was Philippe Jabre, a trader for GLG Partners. He had to pay £750,000 two years ago on charges of insider dealing relating to trading in Mitsui Financial Group in 2003.
Chris Rexworthy, the director of institutional business and former head of wholesale supervision at hedge fund research firm IMS Consulting, said: "Those that made first trades and the largest trades after the rumours started will be looking over their shoulders. The FSA will undoubtedly call them to ask: 'why did you do that?'"
Industry participants have suggested that those funds immediately under scrutiny will be any alternative managers who have a special situations fund that traded heavily in HBOS on Wednesday. However, the regulator is under no illusions over the size of the task it faces. "This will be very labour-intensive in what is a pretty opaque part of the market. It is frustrating, but we know that, and know what the task is that faces us. We are going to be working very hard on this," the FSA spokeswoman added.
The problem for the regulators is the difficulty of tracking the genesis of such rumours. They can start on internet bulletin boards and messaging sites. Managers can use untracked messaging, mobile phones or simply meet in coffee shops to exchange ideas are common. No traders looking to move a stock would be caught on their work email or telephone saying anything suspicious, as both are easily tracked. Some investment bank trading floors have banned certain instant messaging providers and mobile phone use, but that is by no means the industry standard.
With many funds operating across borders, the investigation will also have to be international. The Irish authorities, for example, said yesterday they were investigating events linked to the HBOS raid.
Mr Buckingham of Herbert Smith said: "It is really hard to track down someone doing this. The problem is that rumours spread so fast it is almost impossible to trace them back to the source. The FSA is toughening up, however, and if it finds whoever started the rumour it will surely throw the book at them."
Should anyone be caught red handed driving down the price of a stock for material gain, they could face either civil or criminal charges. Mr Buckingham said it is easier to press civil charges as the case only has to prove the trader's guilt on the balance of probability. In that event, the individual trader could face fines and a ban from operating in the UK. Should the charges be proved beyond reasonable doubt, then it becomes criminal and the guilty party faces a jail term of up to seven years.
Mr Buckingham said: "The main difference between a civil and criminal charge is the burden of proof. For criminal charges there is a higher standard to satisfy, and there has been a problem in the past getting that level of evidence."
One expert warned that this episode could be the very stick the FSA has been looking for to beat the hedge fund industry with. "The regulators have been very interested in hedge funds over their disclosure and potential market manipulation. This only gives them more incentive to put in market abuse controls on the industry."
The hedge fund source said: "This will have a knock on effect in the industry, and we're really worried about knee-jerk reaction from the politicians."
How the rogue operators tried to hammer HBOS
The strategy of short selling has been forced into the limelight, after it was abused by traders looking to hammer HBOS's stock to generate huge profits on a frenetic day of trading.
The tactic, heavily employed by hedge funds, investment banks' proprietary trading desks and wealthy investors, is fundamentally a bet that a stock is overvalued and makes money if the price falls. It is carried out by a trader who borrows stock from long-term investors for a fee, before immediately selling those shares on.
The short seller will buy back the stock at a set date – which is known as "as covering the short" – and return it to the lender. If the share price had fallen in the meantime, the shorter will pocket the difference.
Northern Rock, which saw its share price fall in value from £12 at the beginning of last year to 63p, was targeted by shorters including Lansdowne Partners, GLG and Marshall Wace. As long investors saw their holdings evaporate, the short sellers made more than £1bn.
Chris Rexworthy, director of institutional business and former head of wholesale supervision at the hedge fund research firm IMS Consulting, said: "Short selling is regarded as a perfectly legitimate trading activity. People should be allowed to bet on share price moves in either direction. It is part of the dynamics of the market."
There was also talk of US hedge funds successfully shorting Bear Stearns.
A spokesman for the Alternative Investment Management Association, the industry trade body, said: "Borrowing stock and then selling it to take a short position in a company's shares – thereby hoping to profit from a price fall – is a completely legitimate... practice by hedge funds and many other market participants. Spreading rumours about a company being in trouble or acting in concert with others in order to manipulate a lower share price, however, is market abuse and is illegal."
This week, the amount of HBOS stock on loan amounted to 9 per cent of the total register, according to Data Explorers. That number of shares on loan had more than doubled by the time the rumours of its liquidity issues hit the market, compared with three weeks before.
Peter Montagnon, director of investment affairs at the Association of British Insurers, said: "This is the most egregious example of market manipulation imaginable. In the end it hurts all those with legitimate business in the market."